Reserve Study Basics
There are an estimated 342,000 community associations in the United States today and that number is growing rapidly, but only a small percentage of those communities have the financial protection provided through a professional Reserve Study to ensure the continued value of the common community assets.
It is well known that the board of directors of an association has the fiduciary duty and responsibility to preserve, maintain and enhance the value of the assets of the community because that value directly affects the value of each owner’s unit or property. A professional Reserve Study provides the board with the necessary information to perform its duty and make important financial decisions on behalf of the association.
To get started down the path of financial health for an association, a series of initial critical questions by each homeowner and board member needs to be asked including, “when should an original Reserve Study be created, and why?"
The timing for establishing a Reserve Study should be prior to setting the initial homeowner assessment. That means that the developer should initiate a Reserve Study prior to the first sale of a unit. Although in most states a developer is not required to establish a Reserve Fund, it is the most prudent and proper thing to do to start an association off on the right financial foot.
Since it is an indisputable fact that Reserve expenses are inevitable, the answer to the “why” question is simple really. Without a formal assessment and analysis of the capital components of an association, an association may well fall short in its budgeting requirements and fail to adequately fund when necessary to achieve proper care of its infrastructure.
This leads to another significant question; “How prepared are we financially to ensure that we can maintain the value of our community assets?" Since the duty of the board of directors is to make decisions that positively affect the value of the assets of the community, there must be a financial test to ensure this duty is fulfilled.
This test requires each board member to ask; “How do we stay financially strong and protect the value of our assets so as to avoid the need for a surprise special assessment, the borrowing of funds, or the loss of use of enjoyment of a community amenity?" Each board will accept their own respective level of risk, and the use of professionals in the field should assist them in their duty to assess the risk and provide them with information useful in reaching a decision for their community.
WHAT A CLIENT SHOULD LOOK FOR
A Reserve Study should provide at least four things for the client:
- A formal identification and analysis of each capital component that the association is responsible to maintain.
- An estimate of the useful life, the remaining useful life, and the current quality of each of the components identified.
- The cost in today’s dollars to replace, repair, maintain, refurbish, and/or enhance each of those respective components.
- A financial funding model that considers how the association will pay to repair, replace or refurbish the capital assets to an acceptable level of quality and use.
To provide valuable decision-making information to the board, a Reserve Study should determine the basis for a Fully Funded model. This financial model portrays the funding necessary to ensure enough money is available at the time that each asset is anticipated to be replaced, repaired, refurbished, etc.
Any amount of funding that is less than a Fully Funded model, presents a graduated risk to the association of having inadequate funds available at the time money is needed. Such risk may be acceptable to an association but may also result in the need for a possible special assessment, the need to borrow money, or the loss of use of an asset. Simply stated, the less funding the higher the risk, and the risk of financial inadequacy is measurable.
A more practical reason to Fully Fund the Reserve Fund is fairness. Everyone who uses or enjoys the benefit of an asset of the association over time should help fund the replacement or repair of that asset over the period they’ve used or enjoyed it. For example, everyone who uses the road should contribute to its maintenance and replacement – a simple, yet practical principle.
It is vital to the financial health of an association to provide for a Reserve Fund analysis of the capital, common-area assets, and then fund the Reserve Fund model desired to ensure the on-going quality that the members of the association expect and have invested in.
Remember that an association will need to use funds in the future to maintain its assets, it’s just a matter of how each one plans to acquire, hold and spend those funds.
RESERVE STUDY MYTHS
There are several “myths” about Reserve Funds that professionals hear and deal with on regular basis. Here are responses to a few of them:
“I won’t be here when that needs to be replaced!” It is true that certain members of an association may pay into a Reserve Fund without ever seeing the result of their savings, however, their use and enjoyment of those assets establishes their responsibility to pay for them and is an added value to their own unit when they do decide to sell. The buying public is becoming increasingly aware of the need to investigate the financial health of an association that they’re going to potentially buy into. An unfunded or underfunded Reserve Fund may signal financial trouble for an association resulting in a new buyer potentially being saddled with a special assessment.
- “If it’s not listed in the plan, we can’t pay for it out of Reserves.” A reserve plan is an estimate of values of major components. There may be an occasion when a capital cost to repair or replace something wasn’t consider in the funding model, but it is ok to use the Reserve Fund to pay for capital items that were not necessarily planned for in the analysis.
- “Shouldn’t this be an engineering analysis?” In some cases, it is necessary to have an engineering analysis performed on a major, critical capital asset, but since a Reserve Study is an estimate of future values for the purpose of establishing a fund, an engineering analysis is not necessarily required. In addition, an estimating service is generally far less expensive than the cost of an engineering analysis.
- “We can’t fund for that because we don’t own it!” Some associations have chosen to maintain or care for areas that are not particularly owned by the association but may impact the value of the community. As an example, unit doors may be owned and the responsibility of the unit owner, but the association may choose to maintain those doors to ensure a certain level of quality appearance.
- “We’re really a unique association so we don’t need a Reserve plan!” Every association is unique, but the basis for performing a Reserve Study is uniform (as described above). Each aspect of an association should be considered when developing a Reserve Study, and each report should reflect the unique characteristics of that association.
- We can’t Reserve for future growth.” It is true that a Reserve Study is based on existing assets of the association. It is highly recommended to talk to your accountant about such matters, but generally setting aside funds for growth in the association should occur through a “Capital Improvement Fund”. Once an improvement is initiated, it should then be added to the Reserve Fund to fund for future repair or replacement consideration.
- “The developer should have funded our Reserve plan more!” Well actually, that is only partially true. The developer is not going to fund the Reserve program from his or her own pocket. So, what the developer should have done was set the initial assessment at a level that would allow the association to start funding its own Reserve program from the beginning of its existence.
- “We can do this Reserve Study ourselves.” In some instances, this is true. Typically, when an association has few minor components. Getting bids from contractors to deal with those components is the best way to know what it will actually cost to maintain, repair or replace specific components. But generally, a Reserve Study involves a complicated analysis of identifying proper components and then developing true costs associated with repairing or replacing those components in the future.
- We’re not legally bound to put a Reserve Study together.” Although this may be a true statement in states where no state statute exists to require an association to do so, it is a basic principle of prudent business practice by a board of directors and fulfills their fiduciary duty.
- “But we had a plan done years ago - we don’t need another one!” Since maintaining the community assets in an association is an on-going practice, and since the only thing that’s constant is change, it is prudent for an association to update their Reserve Study annually to incorporate all changes to assets, and their financial situation.
Robert Felix, PCAM, RS
The Felix Reserve Group